This article appeared in the March 2012 ASX Investor Update
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Lean how to improve portfolio returns and efficiency with soft-commodity ETFs.

By Tony Rumble, BetaShares

Investors are familiar with the boom in commodity prices and experience the effects of rising prices for those they use, petrol being the most obvious. Australian investors are "enjoying" the fruits of the boom through the high inflows of capital into our economy, and at the same time suffering under the high interest rates the inflation-fighting Reserve Bank of Australia is imposing in response.

So investing in commodities should be a way to generate returns as well as a hedge to protect your investments against the rising costs flowing from the boom. Because Australia is apparently in a long-term commodities "supercycle" - linked to the urbanisation and industrialisation of China, India and other emerging economies - we ought to be thinking that investing in commodities is important now and for the future.

It is not that simple. Post-GFC investor scepticism combined with the "black box" of commodity prices - how much of the price is driven by hedge fund speculation and hoarding? - has traditionally forced most investors to stay away from commodities as an asset class.

This article provides a balanced analysis of the pros and cons of agricultural commodity investing and how to include it in portfolios, with guidance on how to interpret and react to the "noise" surrounding commodities. There has been a huge shift in the production and consumption of most commodities, with agricultural (soft) commodities subject to the same explosive demand growth that is driving prices for hard commodities.

Portfolio efficiency can be improved by including 5-10 per cent agricultural commodity exposure by, for example, using the BetaShares ETF (ASX code: QAG).

Commodity boom sustainability

Commentators say the current commodity boom is driven by the growth and industrialisation in emerging economies, which overlays the normal demand from developed economies. This typically leads to research by brokers and investment managers that encourages investors to buy resource-related shares and also invest in the underlying commodities. In parallel, we also hear claims that the China story is a bubble waiting to burst and that economic growth in emerging markets is likewise uncertain.

With a heavy dose of scepticism in mind, let's look at the evidence of how real this commodities boom is, what are the enduring sources of high prices, and what are the risks for investors. We will see that the drivers of demand for the soft agricultural commodities (wheat, rice, corn, etc) are very similar to those of hard commodities (iron ore, coal, copper, etc).

The Reserve Bank of Australia is one of the most consistently accurate economic forecasters available to us. In November 2010 its governor, Glenn Stevens, highlighted how much stronger the commodities boom was than any of its predecessors.

Australian Terms of Trade

Source: RBA

Stevens noted that commodity prices have always experienced a "boom and bust" cycle in Australia, going so far as to say the RBA assumes that iron ore prices will moderate over coming years as supply increases to match demand. Yet he was clear that there was a reasonable basis for the view that the boom may be "longer and stronger" than previous ones.

The chart above, which Stevens used in his speech to the Committee for Economic Development of Australia (CEDA), makes it clear that, despite the various booms during the 19th and 20th centuries, the long-term trend in commodity prices was downward for all of the 20th century. This leads many commodity sceptics to predict the current boom may just be a blip in demand, and therefore commodity investing will end in tears.

A great source of analysis comes from the eminent investor Jeremy Grantham, founder of investment house GMO. As a noted sceptic of broker and investment bank claims about rising asset prices, his detailed analysis of the "paradigm shift" in commodity prices is a must read for all investors. This is what he says about the current commodity boom:

"…we now live in a different, more constrained, world in which prices of raw materials will rise and shortages will be common…accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources. After 100 years or more of price declines, they are now rising and in the last eight years have undone, remarkably, the effects of the 100-year price decline."

Grantham names the Chinese industrial revolution, which grew exponentially after China joined the World Trade Organisation in 2001, as the primary source of the "great paradigm shift" in commodity prices.

The table below shows how extensive Chinese demand is for commodities.

Note that China's demand for agricultural commodities sits side by side with its demand for hard commodities. China now accounts for 28.1 per cent of the global demand for rice, 24.6 per cent of soybeans, 16.6 per cent of wheat, and nearly half the entire demand for pork.

It is no wonder the rise of China and other emerging economies is fuelling such a significant increase in commodity prices. The graph below illustrates this with iron ore prices.

Iron Ore prices chart - 1900 to 2010

Source: Global Financial Data, as of 31/12/10

The case for investing in agricultural commodities

The urbanisation and industrialisation of the emerging economies, led by China and India, has many facets. Demand for hard commodities comes from the building of infrastructure needed to house and transport the hundreds of millions of people moving from rural to city life.

Their jobs in the cities are typically far more productive of national wealth than their lives as farmers. This leads to rising national GDP, which directly creates rising household GDP. As household incomes rise, more citizens consume more electrical and whitegoods, thus increasing demand for hard commodities. The quality of food improves, with rising consumption of protein and calories. This directly leads to higher demand for the key soft commodities of wheat, rice, soybeans, etc.

The finite supply of hard commodities is a primary reason for their rising prices, compounded by the higher cost of extracting and processing lower-quality deposits, which is necessary as higher-quality deposits are mined out. It is the same with agricultural commodities: as demand grows, production moves to marginally lower-quality land. This is exacerbated by the growth in size and number of urban centres; typically cities are established in geographic regions with good supplies of water and good growing conditions for crops. As cities grow, they overwhelm the best agricultural land. Australians know this only too well with urban sprawl.

Agricultural productivity has been helped over the past few decades by improved fertilizers and farming techniques. Even though total output has risen, the efficiency of agriculture is falling because of the declining quality of land used. The graph below shows this decline is permanent, and there will be a fundamental shift as petrochemical-based fertilizers become more expensive.

Agricultural productivity chart - 1971 to 2006

Source: Food Agriculture Organization of the United National, as of 31/12/2009

It is little wonder that the prices of the four key agricultural commodities - wheat, rice, soybeans and corn - are high, and moving higher.

Portfolio construction with agricultural commodities

The problem for investors is that it is impossible to buy most physical commodities unless you are a supplier or end-user of them. How does a retail investor store an investment in wheat?

Investors seeking exposure to commodity prices have traditionally done so through owning shares in commodity companies. This works reasonably well with hard commodities, but is difficult to do in agriculture. The total exposure to soft commodities of companies in the ASX 200 is less than 1 per cent.

As a result, various commodity indices have been developed to provide a convenient method of investment in agricultural commodities. The graph below shows the performance of the leading global commodity index, the S&P GSCI index, compared to that of the ASX 200 and the S&P 500.

Commodity index comparisons

Source: BetaShares

BetaShares provides a range of commodity ETFs, including a diversified commodity basket (ASX code: QCB), an energy ETF (ASX code: OOO), a gold bullion ETF (ASX code: QAU) and a metals ETF (ASX code: QCP). The BetaShares agriculture commodity ETF (ASX Code: QAG) tracks the S&P GSCI Agriculture Enhanced Select Index and is a useful tool for blending with more traditional assets such as Australian or international shares.

The graph below shows how the performance of an Australian equities portfolio can be improved by the inclusion of a 10 per cent allocation to QAG.

Australian equities portfolio with inclusion of 10% allocation to QAG

Source: Mercer, BetaShares. Blending QAG with ASX 200.

Conclusions

Driven by the urbanisation and economic growth in emerging economies, and decreasing rates of agricultural productivity, agricultural commodities prices are rising and should continue to do so as these fundamentals continue their trend growth. A portfolio allocation into the BetaShares agricultural ETF QAG improves the overall return and portfolio efficiency for retail investors.

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